A Long-Term Investor’s Perspective on High Inflation & Rising Interest Rates

Investors’ heads are spinning from what seems to be a mountain of challenges facing the economy today. Allow me to use an analogy. Have you ever plugged your health symptoms into Google? You almost always get results that seem much more serious than the actual diagnosis. Because of the amount of volatility, uncertainty and “noise,” we want to put this current situation into perspective for a long-term investor. 

What Is The Diagnosis?

First let’s talk about the direction of the economy today. The rate of growth for the U.S. economy was negative in 1Q22 by an annualized rate of -1.5%, well below the 6.9% rate recorded in 4Q21. Despite this downturn, there were several areas of strength in the first quarter, including investments into overall personal consumption expenditures up 3.1%, personal consumption expenditures on durable goods up 6.8%, investment into equipment, which rose by 13.2%, and investment into intellectual property products, which increased by 9.2%. Inventories grew for the second quarter in a row, a hopeful sign that the worst of the supply-chain crisis may be over. 

Some areas of the economy are showing cracks around the edges. Personal consumption expenditures on nondurable goods were down 3.7% due to reduced consumption of gasoline and other energy products. Export goods declined 8.9%, due in part to the Russian invasion of Ukraine as well as COVID shutdowns in China. Government spending was also lower by 2.7% as COVID-related fiscal stimulus programs waned. Finally, spending on imports, which counts against U.S. GDP growth, surged for the second quarter in a row, rising 18%.

Recently we learned, if rising costs at the gas pump and sticker prices at the grocery store were not proof enough, that inflation continued at the red-hot pace of 8.6% in May. This is the highest level since December of 1981. Energy prices rose 34.6%, with gas prices up 48.7%, fuel oil up 106.7% (the largest increase on record), electricity up a bargain 12%, and natural gas up 30.2%. Food costs surged by 10.1%, the first increase over 10% since March 1981. Wholesale prices rose 10.8% through May, a slight decline from the record 11.5% hit earlier this year. 

The Federal Reserve increased the federal funds rate by 75 basis points to 1.5%-1.75% during its June 2022 meeting, instead of the .5% initially projected, after the inflation rate accelerated last month to 41-year highs. It is the largest single rate increase since 1994. Fed Chair Powell signaled that a similar move could come at the end of July and that ongoing increases in the target fed funds range will be appropriate. By increasing short-term interest rates, the Fed is trying to put the brakes on the economy but not so much that it stalls and dips into a recession — a “soft landing,” if you will. 

What If We Have A Recession? 

There have been 11 recessions since 1948, averaging out to about one recession every six years. The average recession before 2007 lasted about 11 months. The Great Recession lasted 18 months. The 2020 recession recorded the steepest decline in GDP since the Great Depression, with the U.S. economy contracting by a record 31.2% in the second quarter after falling 5.1% in the previous quarter. It was also the shortest on record, lasting just two months. It should be said that the odds of a recession are elevated given persistent inflation and the Federal Reserve’s efforts to slow demand to match supply more closely. So, how do stocks perform when the economy is faced with a recession? Surprisingly, the S&P 500 rose an average of 1% during all recession periods since 1945. That’s because markets usually top out before the start of recessions and bottom out before their conclusion.

Both higher prices and rising rates already appear to be impacting economic activity. Data for May show a 14.4% monthly slowdown in housing starts as mortgage rates tipped up over 6%. Consumer spending has been more than solid, but retail sales dropped by -.3% in May as higher prices and borrowing costs hurt spending on non-essential goods. The University of Michigan consumer sentiment survey, dating back to 1952, hit a record low in June. Americans’ expectations for overall inflation over the next year rose to 5.4% in June from 3.3% in May, while expectations for inflation over the next five years jumped to 3.3% from 3% in the prior month. The bleak outlook is comparable to the trough reached during the 1980 recession. 

What Are Investors Worried About? 

Financial markets have struggled in what is the worst start to a year in decades. Investors are grappling with the impact of rising interest rates, high inflation and energy costs, the war in Ukraine, and a slowdown in China's economy, prompting investors to reconsider the prices they're willing to pay for stocks. Interest rates, which are rising quickly because of the high inflation hammering the economy, are a headwind for equity markets. Low rates act like steroids for stocks and other equity investments, and Wall Street is now going through withdrawal.

Bear markets are fairly common, with the last one occurring just two years ago as the pandemic locked down the U.S. economy. That bear market, which lasted from February 19, 2020, to March 23, 2020, was the shortest ever on record for the S&P 500. The index fell 34% in that one-month period as investors reacted to lockdown orders that closed businesses and kept consumers at home. Most long-term investors will endure many bear markets in their lifetime. There have been ten since 1980, when the market declined by more than 20% and the downturn endured for more than two months. The average bear market decline has been 28% and lasted an average of 236 days. The good news is that bull markets continue for longer, an average of 852 days, and produce attractive average returns of +99%. While the declines can be nerve-wracking and painful, this is ultimately the price we pay for participating in strong returns over time. Despite multiple bear markets since 1980, the average annual total return for the S&P 500 is 9.52%.

A Tempting Idea

So, you say, why not just sell stocks and sit on the sidelines until the bear market is over? While selling stocks would stop the bleeding, it would also prevent any potential gains. Many of the best days for the market have occurred either during a bear market or just after the end of one. For example, in the middle of the 2007-2009 bear market, there were two separate days where the S&P 500 surged roughly 11%, as well as jumps of better than 9% during and shortly after the roughly month-long 2020 bear market. Further, there is a strong correlation between troughs in consumer sentiment and attractive equity returns in the subsequent 12 months. Time is your friend in the equity markets, with the probability for negative returns declining as your holding period increases. 

That said, given that the environment we are in is different than what we have enjoyed for the last many years, one with higher rates of inflation and higher and rising interest rates, we have taken steps to broaden our diversification to include high-quality, dividend-paying stocks, real estate, and commodities, while lowering our exposure to growth strategies. 

We know this can be an unnerving time for investors. Your highly experienced team of First Business Private Wealth advisors welcome the opportunity to talk with you about your individual situation. Periods of volatility are an excellent time to revisit your financial plan and make certain that you remain on track to achieve your goals and objectives over time.